To illustrate how this project has taken several turns, here is a brief history.  The project was initially added to the FASB’s agenda in May 2007 as an effort to converge standards with IFRS, which already requires that managers make the going-concern assessment.  The other objective of the initial project was to determine when the liquidation basis of accounting should be adopted.  After being removed as a separate project from the Board’s agenda, it later resurfaced as the Board expanded its scope in mid-2009 to include enhanced disclosures about risks and uncertainties (motivated by events surrounding the financial crisis), and a definition for substantial doubt.  The idea behind the enhanced disclosures was that managers would provide early warning signals to users about conditions and events that indicate the entity will not be able to meet its obligations within the foreseeable future without significant actions taken outside its ordinary course of business.  These requirements require a triggering event, and over the course of further deliberations, the Board determined that the disclosures should escalate as the economic conditions surrounding the entity become more severe.

In a 2011 October meeting, the Board decided that providing early warning signals would not be an objective of the project because identifying the triggering event is problematic, and similar disclosures pertaining to liquidity were being deliberated on another project.  As I wrote here, defining substantial doubt remained a significant challenge and the project’s primary objective was now to determine whether management should be ultimately responsible for the going-concern assessment. 

With Wednesday’s decision, the Board has again expressed a preference for providing early warning disclosures such that when a going concern assessment is made by the auditor, users will not be surprised.  Some board members expressed a concern that since substantial doubt is a term used in the auditing and securities law literatures, the FASB should not be trying to define what that term means because developing a definition could potentially be different from the intended meaning.  (My opinion is still that a clear definition for substantial doubt is essential, but it appears that definition will need to be developed by regulators who initially created the term.)

Other opinions expressed by Board members and outreach groups (particularly users) do not appear to be based on empirical evidence and therefore, in my opinion, are great topics for academic research.  The first is the notion that a going concern opinion is a self-fulfilling prophecy and that in expressing the opinion, managers/auditors are leading the charge to the entity’s demise.  However, as I expressed here, there is no strong evidence that I am aware that would support this self-fulfilling prophecy notion and some simple statistics suggest it is a fallacy. 

Second, multiple Board members expressed the opinion that management could not be objective when expressing their opinion.  However, one Board member explicitly rejected that notion on the basis that management is asked to provide objective evidence in several other places within the financial statements.  With management going-concern opinions from IFRS, it would seem that data are available for academics to directly test this notion.

The Act imposes an annual fee on health insurers (beginning in 2014) that is based on the firm’s net premiums written during the preceding year (year t-1).  The fee becomes payable on day 1 of year t as long as the firm continues with business on day 1, and the fee is due no later than September 30. 

The EITF took up the issue of how health insurers should account for these fees, and prior to that, how pharmaceutical companies should account for similar fees levied against them by these Acts. A consensus is reached on EITF issues when no more than three members present at the meeting object to the proposed position.  The consensus position must be exposed for public comment and ratified by the FASB. 

In the case of fees levied by these Acts (both for health insurers and pharma co’s), the EITF consensus is to require that firms estimate a full liability on day 1 of year t for the obligation to pay the annual fee, which is the date the obligation is legally payable to the government.  The debit is a deferred cost that is amortized on a straight-line basis over the calendar year.  In taking this view, the EITF noted that industry participants view the fee as a cost to participate in the government programs for year t, which justifies recognizing the expense throughout year t.  While sales in year t-1 is used to measure the liability, this is viewed merely as a measurement mechanism and not a triggering event to recognize the liability.

The Board ratified this decision with a 6-1 vote.  Let’s consider the contrarian point of view.

The fee is essentially a tax that is based on revenues from contracts written in year t-1. We are OK with GAAP requiring that income tax expense be recognized in the same year that income is recognized, because that is a better reflection of operating profit, even though the tax isn’t necessarily paid in that year.  Why, then are similar government fees not recognized when the corresponding revenues upon that fee is based is recognized?  

The Task Force decided that “the fee does not represent a cost related to the acquisition of policies that is consistent with the definition of an acquisition cost….”  However, paragraph 944-30-55-1A of the Codification states that direct acquisition costs are “…costs related directly to the insurer’s acquisition activities … that would not have been incurred by the insurance entity had the acquisition contract transaction(s) not occurred.”  That seems to describe the new government fee, as the fee would not exist had revenue not been generated in year t-1.

The one FASB dissenting vote on this ASU was made by Hal Schroeder.  The basis for his dissent can be read in the document, but essentially, he suggests that firms are incurring a constructive liability in year t-1 when they recognized revenues, which should be accrued and fully recognized by day 1 of year t.  Given that we assume firms are going concerns, this seems like a reasonable position. 

If anyone has other views or knows of academic research that can shed light on this issue, I would be interested to hear your comments.  At least, this case might provide material to stimulate class discussion on what constitutes a liability and appropriate expense recognition.

This project was, until late last year, slated to be finished in July 2011. However, given the majors changes that have been raised during redeliberations, the boards have concluded that they are likely to end up with a document that would require re-exposure.

Given that they have not yet finished their redeliberations of the original exposure draft, it is difficult to say how far back this will push a likely completion date. The current plan is to finish redeliberations in Q3 of 2011. They would then need to finalize and ballot a new exposure draft. Assuming a 3-month exposure period and a few months for deliberations given the new feedback, and then another round of votes, I think it is safe to assume that this will push completion into 2012 at the earliest. However, the best place to find out more is to monitor the leasing project page.

You can read the full press release from the FASB here.

• A list of G20 countries and their current IFRS policy (p. 3)
• A great statement by Sir David Tweedie in which he talks about the mission and history of the IFRS Foundation (p. 22-26)
• Summaries of technical activities in 2010
• Financials for the IFRS Foundation

Great pre-reading (especially p.3 and 22-26) for a lecture discussing IFRS and GAAP convergence.

The proposal in the boards proposed ASU on lease accounting would have allowed lessees to book the right of use asset and the associated lease obligation at the undiscounted amount of the lease payments (which is different than what would be required for long-term leases) or to book nothing at all. Either way, the income statement effect would be similar to what we have today for typical operating leases, but the balance sheet would look different depending on which of the three methods a company chose to adopt. Moreover, this option would exist at the individual lease level, rather than at the level of the reporting entity.

In my opinion, the point of representational faithfulness and comparability is to get the underlying economics correct so that users can identify true similarities and differences across firms (or for the same firm across time). Personally, I don’t see a clear benefit from allowing firms discretion over how to account for short-term leases on their balance sheets, especially on a lease-by-lease basis.

During redeliberations, the boards have shifted position slightly. According to a recent update on the joint project (available here),

The boards tentatively decided that, for short-term leases, a lessee need not recognise lease assets or lease liabilities. For those leases, the lessee should recognise lease payments in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis is more
representative of the time pattern in which use is derived from the underlying asset. Nine IASB members and six FASB members agreed.

The boards also tentatively decided that a lessee may elect to apply the recognition and measurement requirements in the leases guidance to short-term leases. Twelve IASB members and five FASB members agreed.

If I understand this correctly, it seems the boards have moved from three options back to two – either measure all lease assets/obligations the same or treat a short-term lease like a current operating lease. Seems like a step in the right direction, especially if the latter option is available more for practicability than for conceptual soundness.

Despite 30 years of defending a balance sheet perspective, the Board still on occasion makes decisions that seem to be driven by a belief about the “right” amount of income to recognize in a given period. Balance sheet line items are, in those moments, stripped of their conceptual primacy and become mere plugs between income statement amounts.

While there are (unfortunately) numerous examples of this inconsistency (e.g., anytime the possibility of a day-one gain arises), I was prompted to write this post by a recent tentative decision as part of the redeliberations on leasing. One of the proposed changes to the leasing ED would be to create a distinction between “finance” leases and “other-than-finance” leases. Unlike the current distinction between a capital and an operating lease, both of these new lease types would be capitalized on book. However, similar to the current distinction, a finance lease would show up on the income statement as interest and amortization amounts, whereas the other-than-finance lease would simply reflect rent expense.

Given that the right-of-use asset associated with the other-than-finance lease will have to be amortized, you might wonder how a straight-line expense pattern would arise. The tentative decision is to measure the amortization of the right-of-use asset as the difference between the straight-line expense amount and the interest expense amount.

While there might be economic meaning in the asset measurement being proposed for an other-than-finance lease, I’m not seeing it. Seems like a plug to me…a plug necessary to get the income statement expense to the “right” amount.

I wonder what Sprouse would say if he were at the table during these redeliberations?

This provides an important opportunity to offer your perspective on factors to consider in structuring an organization charged with world-wide standard setting. What would need to change in order for you to be comfortable with a possible SEC decision to require/allow U.S. companies to file financial statements using IFRS without a reconciliation to any other form of GAAP?

The document poses some interesting questions (paraphrased): (1) What sound be the objective of financial reporting? (2) Should standard setters take into consideration the potential effects of new standards on economic behavior? What is the role of neutrality? (3) To whom should the organization be accountable? For what should the organization be accountable? What does it mean for the organization to be independent? (4) What is the role of national standard setting bodies in a world where an international body (i.e., the IASB) determines GAAP? (5) What should be the nature of due process? (6) How should the organization go about providing follow-on guidance for new standards? (7) How should the organization be funded?

The comment deadline is February 24, 2011. This is a unique opportunity for impact by students, professors, and AAA/FARS committees charged with commenting on financial reporting standards and the standard setting process.

Much of the progress report is dedicated to explaining what the SEC staff is doing to complete the Work Plan. Of course, the really interesting material is not so much in what they are doing or plan to do, but rather what they have or will conclude based on their findings. To that end, this progress report does not disappoint. I’ve had a chance to read through the progress report, and it has some interesting content. You should, of course, read it for yourself, but here are some of the highlights for me.

• The report highlights several recent events, including the FASB and IASB adjustments to the MoU timetable, the FAF decision to move to seven board members on the FASB, and the retirement of FASB Chairman Bob Herz, and notes that the Commission believes it will still be able to make a decision in 2011 as originally anticipated.
• In Section I, “Sufficient Development and Application of IFRS for the U.S. Domestic Reporting System”, Subsection C.2 provides an interesting summary of the various methods for incorporating IFRS into a domestic financial reporting system. The Staff’s research indicates that very few large jurisdictions adopt IFRS as is without having a mechanism in place to potentially change those standards. Instead, most jurisdictions have a form of national incorporation. Some countries, such as China, use a “Convergence Approach”, but the “vast majority” of the countries the Staff examined use an “Endorsement Approach”, including the European Union.
• In my opinion, the analysis of the EU version of endorsement is particularly telling, as it details how “with each step, there is an opportunity to consider and potentially modify the standard issued by the IASB.” This version of endorsement can be contrasted with the Australian model, which “has kept pace with the final standards issued by the IASB, with each new standard being issued with the same application date as set by the IASB.”
• Section I.C.3 identifies the many roles that national standard setters have continued to play around the world, and notes that “the majority of…jurisdictions [that had previously made use of a private sector standard setter] retain their national standard setter subsequent to incorporating IFRS into their financial reporting systems.”
• In Section II, “Independent Standard Setting for the Benefit of Investors”, the progress report notes that the IFRS Foundation has “no authority to impose funding requirements…[that] the effort to achieve long-term mandatory funding commitments for the IFRS Foundation is not complete…[and that] three out of four countries reported by the IFRS Foundation as permitting or requiring some form of IFRS provide no monetary funding.” In fact, the report identifies that “the two national jurisdictions with the largest contributions in 2009 were the United States…and Japan…neither of which have formally incorporated IFRS into the financial reporting system for their domestic reporting issuers.” The report goes on to note that the “amount of contributions from the United States, relative to those from other jurisdictions, would be even higher if ‘contributed services’ from the FASB through the FASB’s convergence efforts with the IASB were included.”

The report did not offer much in the way of preliminary observations on the following topics, noting that there was still more work to be done under the Work Plan in these areas:

• Investor Understanding and Education Regarding IFRS (Section III)
• Regulatory Environment (Section IV)
• Impact on Issuers (Section V)
• Human Capital Readiness (Section VI)

The one area in Section IV that I thought the report did comment on was the initial feedback to the Commission from industry regulators who expressed “broad support for a single set of high-quality global accounting standards that provide for transparent and comparable financial reporting” tempered by concerns in three areas: significant costs to modify internal processes and systems in support of full convergence, the potential for diminished ability to influence the standard-setting process, and a general absence of industry-specific guidance in IFRS.

Those were the major takeaways that I had. Stay tuned as the SEC plans to provide regular progress reports during the lead up to its decision in 2011 on whether and how to incorporate IFRS into the US financial reporting system.